Prohibited Transaction Exemptions for Employee Benefit Captives

This article is provided by Strategic Risk Services. Contact details for the company can be found at the end of this article. One of the hottest recent topics in the alternative market has been the use of captives to insure employee welfare benefit plans (e.g. health, disability and life insurance). In this article we summarize the history of benefits in captives and discuss some of the practical issues that must be addressed. The article focuses on structures, which use the Individual Prohibited Transaction Exemption ("PTE"), although we acknowledge that there are alternative structures such as corporate reimbursement that may avoid some of the costs and approval processes. ERISA - The Employee Retirement Income Security Act of 1974 is a federal law that sets minimum standards for most voluntarily established pension and health plans in private industry to provide protection for individuals in these plans. ERISA's fiduciary responsibility provisions and prohibited transaction rules require that plan assets be used solely for the purpose of paying benefits or related expenses and prohibit the plan from engaging in transactions with the employer or parties related to the employer. These prohibited transaction rules would ordinarily prevent employers from insuring or reinsuring their employee benefit plans through captives. However, ERISA authorizes the U.S. Department of Labor ("DOL") to grant two types of exemptions from the prohibited transaction rules: 1. Class exemption that may be relied upon by any employer meeting the conditions in the class exemption 2. Individual exemption that can be relied upon by only the employer that applied for the individual exemption. The DOL has granted a class exemption allowing an employer to use its captive to insure or reinsure employee benefits plans if the captive derives no more than 50% of its annual premiums from related business. This requirement has been a major hurdle since most captives focus on related risk and are not interested in exposing risk capital to unrelated business. Individual Exemptions - the Columbia Energy transaction was the first individual exemption allowing the use of a captive for employee benefits without requiring a specific amount of third?party risk. A second individual exemption was granted to Archer Daniels Midland ("ADM"). In both instances, the captive would not have passed the 50% unrelated business requirement in the class exemption. The additional significance of the ADM ruling was that it triggered "EXPRO", an expedited DOL approval process for proposed transactions that are substantially similar to prior transactions. EXPRO allows for approval in as little as 90-120 days compared to approval times in excess of one year for Columbia and ADM. The individual exemptions came with certain conditions detailing how the transaction must be structured, including: the plan will contract only with primary insurers with a rating of A or better from A.M. Best Company;  the plan pays no more than adequate consideration for the insurance or annuity contracts  the formula used to calculate premiums by the primary insurer will be similar to the formulas used by other insurers under similar programs;  the reinsurance contract must be indemnity insurance so that the primary insurer will not be relieved of liability if the captive does not meet its obligations under the reinsurance contract;  the captive must be licensed in at least one U.S. state or territory and must have obtained a Certificate of Compliance from the insurance commissioner in the domiciliary state within 18 months before the sale:  the captive must have undergone a financial examination by the insurance commissioner of its domiciliary state within the five-year period preceding the year of the sale, or by an independent, certified public accountant for its last completed taxable year;  no commissions are paid in connection with the sale;  the captive retains an independent fiduciary, at the captive owner's expense, to analyze the reinsurance arrangement and render an opinion that all conditions in the exemption are satisfied; and  in the initial year of any contract, there will be an immediate and objectively determined benefit to the Plan's participants and beneficiaries in the form of increased benefits. Viability of Benefits in Captives - Now that a framework exists, should captives be looking to fund ERISA benefits? There are both economic and practical issues to consider in this decision:  Economic Benefit: like all captive decisions an evaluation should be made on the cost-benefit of using a captive to fund this exposure, rather than available alternatives. For employee benefits, the captive will need to consider the additional costs imposed by the DOL. These include the costs involved in requiring "A" rated paper, providing increased Plan benefits and retaining an independent fiduciary. The analysis should also consider the economic impact of the improved probability of insurance company tax treatment for all premiums paid to the captive. This is based on an interpretation of Revenue Ruling 92-93, which implies that an employer can use the premiums for employee benefits to satisfy the 30% unrelated business requirement (rule of thumb) to obtain tax deductions for its property and casualty premiums paid to its captive.  Internal Coordination: the decision to involve the captive in the benefits program usually crosses corporate functions (HR, finance and risk management). Many organizations struggle with the internal politics involved. The human resources department in particular may resist the involvement of the captive as it could be perceived as a loss of control. Engaging all of the departments affected by this potential change is critical to the program's success.  Alignment of Interests: the success of captives in funding employee benefits requires the co-operation of life and health insurers. However, this initiative threatens to remove control of assets from the insurers with a consequent loss of revenue. Insurers will look to maintain margin through increases in related fees such as fronting, reinsurance and claims handling. Under a DOL required structure, it is unrealistic for a captive to expect to hold 100% of the assets and aggressively manage program expenses (e.g. fronting and claims costs). The captive and insurer need to coexist and must share in the risk/reward equation to create a proper alignment of interest that will last. Many of the structures implemented are on a quota share basis reflecting this cooperation. Anecdotal evidence suggests that there are inefficiencies in how companies procure benefit programs. These programs can benefit from lessons learned on property and casualty including concepts such as unbundling, self-insurance and captives. Placing benefits in a captive is not a panacea and many issues will affect whether insuring or reinsuring benefits through a captive makes sense. The process of analyzing the current approach versus alternative approaches including a captive will invariably lead to a better understanding of the program and the best structure for each particular situation. About SRS SRS provides underwriting, management and wholesale brokerage services in the alternative insurance market. They design, implement, manage and grow captive and ART programs on behalf of corporations, groups and insurance companies. SRS is an approved manager of captive insurance companies in Arizona, Bermuda, Cayman Islands, South Carolina & Vermont. Through a wholly owned subsidiary SRS is also licensed as an insurance broker in Bermuda. For more information on SRS, visit them at www.strategicrisks.com. Contact: info@strategicrisks.com, Tel: 781 487 9800